Tuesday, June 30 2015
Further to yesterday’s short note on the on-going Greek situation, we highlight that the market’s initial reaction to the potential Grexit has been relatively benign. European markets fell 2% and there did not seem to be the panic that has been associated with other disturbances.
We raise a number of questions:
- Have the markets become a little too blasé with respect to the risk or has the risk of contagion reduced?
- Will the Greeks exit the EU and if so will this cause greater volatility in the market?
- Is value being presented by the market?
Greek exit is not assured, as negotiations will continue until the Greek central bank is instructed by the government to physically print a new currency. Credit controls, default, even the issuing of IOUs are all simply steps that take Greece closer to a euro exit, but are not by themselves critical. In this volatile context, it is essentially impossible to properly price each new item of information, which should, by definition, lead to higher volatility and reduced risk appetite.
Have the markets become a little too blasé with respect to the risk or has the risk of contagion reduced?
The market reaction was reasonably subdued. See for instance the Italian bond yields which spiked reflecting some concerns of contagion yet the yields remain at historically low levels.
Italian bond yields
While volatility has picked up and could remain elevated while we deal with the uncertainty created by the Greek vote, we think the subdued reaction reflects the fact the contagion impact from a Grexit appears containable relative to the uncertainty in 2011/2012. This is due to the following factors:
- Private cross-border debt exposures are now very small. Greek public debt is 80% owned by official lenders such as the IMF and the ECB. Bank exposure is $46b compared to $138b in September 2011.
- Greece is less than 2% of the Eurozone and falling. The EU’s share of Greek imports is only 0.5% of total EU trade or 0.15% of GDP. So the economic impact is not significant.
- The European economy is in better shape with significant reform paying dividends in economies such as Spain (with GDP growth expectation lifting recently to 3%).
- The ability to contain contagion exists. ECB now has the mechanisms to provide liquidity support and increase quantitative easing.
Will the Greeks exit the EU and if so will this cause greater volatility in the market?
Like most things in Europe there remains uncertainty as to what will be the clear trigger for a Greek exit. A missed payment to the IMF on 30 June will not necessarily mean an exit. A ‘no’ vote at the referendum will significantly increase the likelihood but will also not be the trigger. The ECB will need a two-thirds majority to end Greek access to the liquidity assistance.
The bottom line is that nothing is set in stone in Europe. Even rules that are technically written down in treaties can be overruled and modified in times of crisis. The most we can say with certainty is that the ECB is unlikely to see a late payment to the IMF as a clear signal of insolvency. A similar default on a redemption to the ECB itself, however, may be taken differently. That is why the €3.5b redemption due to the ECB on July 20 is the key date for the Greek exit. A ‘no’ vote at the referendum will obviously increase the likelihood of exit because it will empower the Greek Government to withhold payment to creditors.
Is value being presented by the market?
The market has fallen 10% which is a typical size correction in a bull market. The question is whether this has restored value to the market. We have commented in recent months that the PE’s of the market were high but that the market still looked like relative value compared to low interest rates.
A 10% pullback means the PE of the market is on 15x which is still slightly above long-term averages but is not extreme and continues to look attractive in a low interest rate environment. Certainly we are seeing a number of stocks which have pulled back to attractive levels on an absolute and relative value perspective. The grossed up dividend yield of the market is now 6.3% which will also attract investors in the low interest rate environment.
The missing ingredient for the Australian market has been growth. FY15 will be another year without growth thanks to the poor performing resource stocks. The market is currently forecasting 4% growth for FY16 which reflects more conservative expectations but growth forecasts look a little more optimistic for Industrial only stocks (with 8% growth forecast). We continue to focus on those companies which are best placed to deliver growth via:
- Strong business models with structural competitive positions.
- Companies exposed to offshore markets whose profits will benefit from the lower A$.
- Companies exposed to growing segments of the economy (housing, finance and infrastructure), and
- Companies who are undertaking self-help to deliver growth via restructuring.
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